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Beijing Sizes Up a Stimulus Tightrope

John Lee

In the midst of the debacle of a non-explanation for the disappearance of China’s leader-in-waiting Xi Jinping, current Premier Wen Jiabao seems to be one of the few grown-ups running the world’s second largest economy.

One week ago at the World Economic Forum, Premier Wen told Australian business executives what they wanted to hear: China’s economy was ‘stabilising’ and would meet its growth target of 7.5 per cent in 2012. According to the Premier, China has the advantage of having ‘relatively big space for fiscal and monetary police (moves,)’ citing Beijing’s rapid approval of around $US157 billion in planned infrastructure spending as evidence.

Will existing and future monetary and fiscal stimulus by Beijing work? My guess is that it will stave off immediate panic. But if Australian miners and the government are hoping for a return to trend-line growth of around 10 per cent as it has been over two decades for commercial and fiscal health, then it isn’t going to happen. Indeed, the challenge for China is not just about generating enough growth to create and preserve jobs, as important as that remains. It will also be about how to best prevent the bloating of a property bubble, in the quest to artificially generate growth, without bursting it—whilst achieving 7.5-8 per cent growth all at the same time. Now that is a truly difficult balancing act.

A sum of $US157 billion sounds like a lot of money to lubricate growth. Like anything, numbers need to be understood in context. China poured around $US4.5 trillion into fixed investment in 2011. Various indices for manufacturing output—which are heavily biased toward surveys taken from export manufacturing firms—are weak suggesting that export growth will not be a major driver until the United States and European Union recover. Savings has been on an upward trend since 1990, from about 37 per cent of GDP to over 50 per cent of GDP currently. By necessity (since they are the converse of each other,) fixed investment has been rising while consumption has been falling as a percentage of GDP. In other words, any dramatic rise in consumption as a proportion of GDP (which isn’t about to happen) indicates a dramatic fall in fixed investment which has been the dominant driver of growth.

The point is that the only way that China can achieve a ‘soft landing’—defined by most as meeting the target of 7.5 per cent GDP growth in 2012—is by ramping up fixed investment. And $US157 billion is not enough to achieve that.

Of course, the $US157 billion stimulus is only one policy in a kitbag of possible tools and remedies that Beijing can use. Others include lowering lending rates and the deposit reserve ratios for banks, which Beijing has already done several times. This can be complemented by directives issued to banks that they must ramp up lending. This is also likely to occur, as it did from 2008-2010 onwards when lending doubled within a period of 18 months. But Beijing has to be more constrained this time—and the effects of any stimulus for growth will be far less dramatic—for two main reasons.

First, everyone recognises that the last surge of bank lending and fiscal stimulus was way too large, even if Premier Wen expressed few regrets about it at the forum last week. The central government ordered banks to roll-over up to $US1.7 trillion of maturing loans recently, suggesting that a massive bad loans problem is lurking in the system. Total factor productivity dropped from a high of about 10 per cent in 2006-7 to levels of around 4 per cent currently due to the huge capital inputs.

The flood of virtually free money to fixed-investment obsessed state-owned-enterprises (which received around 85 to 90 per cent of all credit from 2008-2010) also led to the widely reported boom in residential property—a state of affairs accurately characterised as a ‘property bubble’. Indeed, in 2010, the ‘house price-income ratio’ in Beijing and Shanghai was 19 and 14 respectively. This compares with 2006 levels of eight in London and seven in New York just prior to the global financial crisis, and 14 in Tokyo in 1991 just prior to Japan entering its lost decade of economic stagnation.

This brings us to the second reason. Although the data is somewhat hazy, a reasonable estimate is that housing construction accounted for around 50 per cent of all fixed investment from 2009-2011, while infrastructure projects and equipment accounted for around 15 per cent and 21 per cent respectively of all fixed investment during the period. Revealingly, residential building starts jumped from around 400 million square metres in early 2009 to almost 900 million square metres in August 2011. Over the same period, residential building sales went up from 300 million square metres to about 500 million square metres over the same period. Clearly, the gap between supply and demand widened considerably.

From 2008-2011, China achieved a dazzling cycle of fixed investment growth because newly acquired residential property assets were used as collateral to trigger even more investment—ven when many of these buildings remain empty to this day. For example, Local Government Finance Vehicles, established by local governments, received a lion-share of bank loans, with most of the capital being poured into residential construction projects. SOEs primarily engaged in non-property sectors used a substantial amount of the free credit on offer to pour money into speculative construction projects. In turn, property assets were used as collateral to access further credit for new investment, much of it being directed back into the property sector. Indeed, an estimated 20 per cent of all bank loans from 2009-2011 have land as collateral, with the ascribed value of that land dependent on clearly unrealistic projections about rising property asset prices and revenues.

Beijing realises that they cannot reply on creating another speculative residential property boom to fuel rapid growth. Tellingly, Premier Wen indicated that the $US157 billion stimulus has been earmarked for infrastructure (rather than property) investment. The problem is that the low-hanging fruit for infrastructure investment has been largely picked. Building a highway from the bustling cities of Beijing to Shanghai makes perfect economic sense and adds genuine value into the economy. But building yet another expensive highway to nowhere doesn’t quite have the same stimulative effect. And building cheap, low-cost housing and modest feeder roads—whilst desperately needed—doesn’t generate the same kind of short-term stimulus for investors that high-end, luxury housing did from 2008-2011.

The bottom line is this. China knows it cannot afford another re-run of the credit explosion or the property boom of 2008-2011. Instead, it will try to oversee a more modest stimulus which is to emphasise fixed investment in infrastructure. This will mean that the secondary stimulus growth effects—however artificial—will not be as pronounced as it was in the recent past.

But Beijing cannot take too much wind out of the property market by making it harder for capital to enter into the segment since any further falls in residential property assets will create a huge problem for its banks, LGFVs and SOEs whose financial health all depend on artificially inflated property prices. Banks know that they will have to eventually write off much of their loans over the past three years. Beijing will delay them having to do so in order to engineer a ‘soft landing’. This is really all the debate about a ‘hard’ versus ‘soft’ landing amounts to. It has nothing to do with genuine economic reform or rebalancing in China.

There are two basic laws of economics that even the most savvy investors and government analysts frequently forget: what can’t happen won’t happen; and what must happen will happen. Unsound investments on a gigantic scale always lead eventually to a gigantic loss of wealth and there will be major losers. Beijing’s kitbag of current and future policies will simply determine who loses the most when reality bites: the government, Chinese Central Bank, banks, LGFVs and SOEs, private investors, or Chinese citizens.

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